Bottom line: Experience from Japan shows that ultra-aggressive central bank bond buying (2013-17), or QE with yield curve control (YCC), can help to suppress nominal and real 10yr yields. However, neither is likely in the U.S. in 2021 onward. Instead, we see a large U.S. budget deficit relative to ongoing Fed buying, helping to push up long-dated U.S. yields in 2021 and 2022.
Figure 1: 10yr Real JGB Yield (%)
Source: Continuum Economics, Datastream
Treasuries and Large Deficits: Lessons from Japan
One focus in global markets is rising U.S. 10yr yields, both due to a rebound in inflation and from the effects of a large budget deficit. Can the Japanese experience provide any lessons on living with large budget deficits?
Figure 1 shows three main phases of 10yr JGB real yields since the global financial crisis. 2009-12 saw 1%-2% real yields, due to both a large government deficit/GDP and persistent negative inflation. 2013-17 saw a shift to zero to -0.5% 10yr real yields (2014 is distorted by the sales tax increase), as BOJ JGB purchases surged. This surge was so large that it not only effectively financed all the budget deficit (Figure 2), but actually prompted a sharp shrinkage in private sector holdings of JGBs. 2018-19 has seen 10yr real yields average around -0.5%, before the fall in Japanese inflation in 2020 flipped real yields positive again. This is the era of QE with YCC, which has translated into a lower proportion of JGBs bought as a percentage of GDP than 2013-17. However, the BOJ is still indirectly more than funding the budget deficit via its bond purchases. This is effective fiscal dominance of BOJ policy by the Japanese government. What does this mean for the U.S.?
Figure 2: Japanese Budget Deficit/GDP and Budget Deficit/GDP (ex BOJ holdings) (%)
Source: Continuum Economics, Datastream
A number of points are worth mentioning in the situation facing the U.S. Treasury market.
- No U.S. fiscal dominance from 2021. The Fed’s $960bn of Treasury purchases in 2021 will likely finance only 25-28% of the U.S. budget deficit, depending on how much of the $1.9trn Biden plan gets through Congress. Fed Chair Jerome Powell has made clear that the Fed will not be dominated by the U.S. government, which means that the 2020 anomaly of negative 10yr real yields is unlikely to be repeated – this was a function of the Fed effectively funding 70% of the U.S. budget deficit.
- When the budget deficit remains large as a proportion of GDP and economic recovery takes hold, as occurred in Japan 2009-12, you can end up with small positive 10yr real yields. In the U.S. we feel that 10yr real yields will eventually gravitate toward 0.25% (close to the 5yr average) and see 10yr Treasury yields at 1.75% and 2.25% for end-2021 and end-2022.
- Japanese real bond yields were also suppressed in 2018-19 by the QE with YCC policy, which actively signals to the market that the central bank will not accept yield levels rising beyond a certain band. The probability of the Fed adopting QE with YCC is now low, with inflation normalizing. It remains possible that the Fed could increase the proportion of purchases at the long end for the remainder of 2021 before 2022 tapering. However, this would slow rather than reverse the prospective rise in 10yr yields we are forecasting.
- It is difficult to translate lessons on inflation and inflation expectations from Japan to the U.S. A rebound in the U.S. inflation trajectory is occurring and we feel this is consistent with the Fed average inflation target. The alternative scenario is that U.S. policymakers run the economy too hot and cause a more persistent rise in inflation. This is unlikely to lead to lower 10yr real yields, but rather to high 10yr nominal and real yields. In this situation, the Fed could taper more quickly and also bring forward the normalization of Fed Funds.
